If you’re a business owner working incredibly long hours, you probably don’t have much time to spend analyzing and selecting outside investments. Or perhaps you simply invest in what feels familiar—stocks, bonds, mutual funds, or limited partnerships that are directly exposed to the same industry in which your company operates. I see this situation all the time, and I cannot emphasize enough the importance of diversifying your investment portfolio away from your business, which is quite likely your most significant asset. Otherwise, you may unwittingly be exposing yourself to excessive levels of financial risk.
Consider Human Capital
I’ll start by introducing the concept of human capital as it applies in finance. You can think of total wealth as comprised of two parts: human capital and financial capital. One common definition of human capital is that it’s a measure of the present value of your anticipated labor income during your working lifetime—in other words, your earnings power. Over the course of your career you convert human capital to financial capital by saving and investing a portion of your income.
Business owners have a particular challenge in that so much of their wealth—both human and financial capital—is tied up in their concentrated (and illiquid) position in their own business. As a business owner, you’re drawing both labor income (e.g., your salary) and investment income (return on your investment in the business) from the company, and the business is typically your principal financial asset as well.
Now, let’s say you’re a retailer or restaurant owner and, due to familiarity, you invest your personal savings outside your company in retail and restaurant stocks and bonds. If consumption slumps in the economy, then quite likely your human and financial capital will be badly affected simultaneously. You don’t want your investment portfolio to be hammered at the same time as your business is suffering. This is why you should keep both in mind when you invest in outside financial assets, with an eye to diversifying your overall portfolio.
Are You a Stock or a Bond?
If your business income is volatile—say, a commission-based business—or it’s highly correlated to the stock market, then we can say that your human capital is “stock-like.” In this case, you may want to consider holding more low-risk fixed income investments and more liquid assets, including cash, in your financial portfolio. (By the way, as with my clients, I suggest that all business owners keep a minimum of 6-12 months of living expenses in the form of cash reserves.) By contrast, if you have a very stable, annuity-like income from your business, then you are more “bond-like” and can probably afford to take more risk in your investment portfolio.
In short, you should look for investments that have a low correlation with your business and human capital in order to maximize diversification benefits over the entire portfolio. One useful way to determine whether an investment is diversifying is to consider risk factors.
Examining Risk Factors
Let’s take the simple case of an owner of a stock brokerage or a market newsletter. This kind of business is obviously subject to stock market cycles that can be vicious. This owner may want to consider a higher weighting in bonds and a below-market weight allocation to financial-sector stocks and bonds in his investment portfolio.
If you’re in the real estate business, then interest rates are a key risk factor. In your portfolio you may want to reduce interest rate risk and avoid property stocks. For retailers, employment and consumer spending are risk factors, so it may be wise to limit exposure to consumer stocks.
The Case of Pension Plans
Finally, I wanted to mention company defined benefit pension plans. If your business offers such a plan to employees, as the plan sponsor, you should consider your firm’s risk exposures when constructing the plan’s portfolio. Ideally you want to minimize the correlation between the market values of the pension portfolio and the operating results of your firm. The last thing you want is for the portfolio and the plan sponsor (you) to take a financial hit at the same time, which may require you to inject funds into the underfunded plan at the same time as the firm’s poor operating results have created cash flow problems. Therefore, for example, if you own a technology or telecoms firm, you probably want to underweight tech in the pension plan and perhaps overweight consumer stocks.
Instead of diversifying their financial risk, many business owners are inadvertently adding to risk when they invest their savings in their portfolios. By analyzing the risk factors to which their enterprises are exposed and making outside investments accordingly, business owners may meaningfully reduce their overall financial risk.
Gregg S. Fisher, CFA, CFP® is president and chief investment officer of Gerstein Fisher, an independent full-service financial advisory firm that he founded in 1993. Gerstein Fisher manages investments on behalf of individuals, families and institutions using a scientific, quantitative research-based approach that is grounded in economic theory and common sense.